Byung-Seong Min unpicks the policy implications of Samsung’s recent crisis and asks whether the time has come to reform the Korean chaebol system of corporate governance.

Samsung Electronics, the leading company in Samsung – South Korea’s largest family-owned business conglomerate (chaebol) – is facing the biggest crisis since its establishment in 1969. The global recall of the Galaxy Note 7s and the subsequent decision to scrap the product altogether, following reports of the phone catching fire, were unprecedented. The total costs of the scrapping, which includes losses from expected sales during the product cycle, are expected to be US$17 billion, and compensation for suppliers’ parts a further US$300 million. More importantly, the debacle has damaged Samsung’s corporate reputation as a global leader in the IT industry and tech giant. An Interbrand analysis ranked this year’s Samsung’s brand value in 7th place, following IBM and Toyota.

Is this an example of ‘winner’s curse’ at work? Samsung, as a fast-follower, has achieved remarkable success. Many global companies have appeared and disappeared in the industry. Sony is no longer a direct competitor. In contrast to Apple, Samsung maintains world-class production technology and capacity to support production of the smartphone. Armed with a short lead-time, Samsung has been the world’s largest seller of smartphones since 2011. At 23.2 per cent in the first quarter of 2016, Samsung’s share of the global smartphone market is bigger than Apple’s by 8.4 per cent.

So what really happened within the company? The Galaxy Note 7 debacle implies the existing managerial strategy and chaebol governance structure should be reconsidered, particularly when technology becomes complex. Though corporate culture among Korean chaebols differs, top-down decision-making from charismatic founders is a common feature. This emperor-style management was effective in enabling Samsung to ‘catch-up’ with the global tech leaders. It is well-known that the development of Samsung from obscurity to a market-leading position owed much to the current chairman, Lee Kun-Hee’s charisma. One of the limitations of top-down management, however, is that senior managers can lack risk management skills in the absence of the top manager’s direction. Indeed, the Galaxy debacle happened at a time when Samsung is experiencing a leadership transition from the second to the third-generation of its founder. Investors expect Lee Jae-Yong, who is the son of Lee Kun-Hee and a vice chairman of Samsung, to succeed his father as chairman of Samsung despite a challenge being launched by US hedge fund, Elliott Management Corp. As a first step, Lee Jae-Yong was appointed an executive director, thereby becoming a member of the company’s board, at Samsung’s Annual General Meeting on 27 October this year.

Most analysts believe Samsung will not make the same mistake twice. The first mistake was launching the Galaxy Note 7 ahead of schedule to get the jump on Apple’s new iPhone. But the real damage to the company’s reputation occurred when replacement phones also started burning up, triggering criticism that both the exchange program and the original launch were haphazard. Senior managers may have been wanting to create a positive environment ahead of the Annual General Meeting so that Lee Jae-Yong would be elected smoothly. The loss of a sense of direction during the chairman’s absence (who has been in hospital for more than two years), as well as an element of moral hazard, could also have contributed to their clumsy risk management. Unfortunately, these factors are often a legacy of a rigid top-down management culture.

The Galaxy incident begs the broader question as to whether the entire chaebol system should be demolished. Radical politicians may advocate dismantling family-controlled chaebols. However, a government policy which directly seeks to dismantle chaebols is neither desirable nor even possible, at least in the immediate to short-term.

Academically, both the advantages and disadvantages of family-controlled business groups have been examined. More than 65 per cent of listed firms in Taiwan are family firms. When Toyota experienced its unprecedented crisis following the massive recall of cars in the US market, the company overcame it by replacing the existing professional managers with an owner-manager (the founder’s grandson). Samsung’s risky investments in the IT industry in 1969 were only possible because the founder-manager paid no heed to the warnings of scholars familiar with modern financial engineering methods.

Corporate governance system of chaebols should, however, be changed. Family members can be top managers as long as their capability is proven to market investors. In many cases, however, the succession in chaebols has occurred without this being the case. Many chairmen of chaebols had not been registered directors, though they wielded excessive voting power compared to their cash flow rights through exploiting the complex ownership structures among affiliates. Observers have pointed to the excessive power wielded by chaebol chairmen without legal responsibility as a significant, contributing factor in the lead up to the debt-ridden growth strategy which in turn caused the 1997 financial crisis. The Korean government reformed the corporate governance system following this crisis. The amended commercial laws require the registration of any de facto top manager. All listed companies must also appoint outside directors to at least 25 per cent of board positions to improve transparency.

The Korean government should ensure that companies effectively implement all these laws so that the traditional (almost) one-way communication culture is replaced by a triangular model where the owner-manager (chairman), professional managers and board members (both internal and external), acting as monitors, maintain a relationship of checks-and-balances. Such a relationship in practice would see a responsible chairman, monitored by the market, laws and the media, who could focus on long-term strategies while delegating substantial managerial decisions to professional managers who are in turn overseen by the executive (including outside directors).

The government should also pay more attention to product safety for domestic consumers. Samsung’s recall decision was directly affected by the investigation from the US Consumer Product Safety Commission, rather than domestically-generated complaints. Most chaebols’ strategies, which have historically been heavily skewed toward international customers at the expense of domestic consumers’ well-being, should be discontinued.